China Sunsine Chemical Holdings Ltd - Catch A Right Time To Expand Production

We expect the current attractive rubber accelerator product spread to sustain for the next couple of years as supply continues to consolidate in China.

Stringent environmental policies in China are phasing out smaller producers in favour of the leading producers such as Sunsine.

Additional growth by capacity ramping by a third to 117k tonnes by 2020.

We initiate a BUY call with a Target Price of S$1.60 (FY18e PE: 10x).

INVESTMENT ACTIONS

Based on a required rate of return of 7.9%, sustainable growth rate of 1%, and FX (SGD/RMB) of 4.85, we derive a Target Price of S$1.60 (FY18e PE: 10x) by free cash flow to equity (FCFE) valuation method and initial a BUY call with an upside of 44.4%.

COMPANY BACKGROUND

Established in 1977 in China, China Sunsine Chemical Holdings Ltd (尚舜化工) was listed in SGX in 2007.

The company is the largest producer of rubber accelerators in the world and the largest producer of insoluble sulphur in China.

It is engaged in the production of specialty chemical, rubber accelerators, antioxidant, and insoluble sulphur. Meanwhile, it also produces and supplies heating power for internal usage and to external customers.

With 40 types of product mix, Sunsine has achieved a leading position in specialty rubber chemical market. The client base expanded to be more than 1,000, including 65% of the top 75 tyre manufacturers.

The production plants are located in Shanxian, Weifang and Dingtao in Shandong Province in China.

By 2017, it is expected the total annual capacity to reach 152k tonnes, comprising of 87k tonnes of rubber accelerators, 45k tonnes of antioxidant, and 20k tonnes of insoluble sulphur.

INVESTMENT THESIS

Overview of rubber chemical sector

Rubber chemicals, also called rubber additives, are ingredients used to blend into either natural or synthetic rubber to produce rubber products that can possess various properties such as anti-oxidation, anti-degradation and extension of lifespan. It is an indispensable intermediate that improves technique and quality in the process of production of rubber products.

The raw materials of rubber chemicals comprise of aniline, carbon disulphide, hydrogen peroxide and morpholine. Aniline is the key chemical that is used for the production of antioxidant and rubber accelerator. Theoretically, aniline consumption ranges from 50% to 70% of per unit production of antioxidant and accelerator. Therefore, the price of it substantially affects the overall cost of production.

90% of the consumption of rubber chemicals is associated with the automobile industry, and 70% of the output is used for the production of car tyres, which consumes 70% of global rubber output averagely. The consumption ratio of rubber chemicals to rubber is 6:100. Therefore, the supply of car tyre markedly drives the demand for rubber chemicals.

China has become the biggest rubber chemical market and expected to consolidate

Over the past 10 years, China has been taking the lead in this niche market. Total production of rubber chemicals in China arrived at 520k tonnes, taking up 45.6% of the global volume in 2008. Since 2013, domestic production surpassed 1mn tonnes along with more than 70% of global market share.

In the recent four years, the total output maintained at above 1.1mn tonnes, and the market share stabilised at c.75%. It is worth noting that more than 80% of the output come from 47 members of China Rubber Industry Association Rubber Chemical Committee. According to China Rubber Industry Association, as of 2016, gross industry output value of rubber chemical sector grew by 5.1% y-o-y to RMB19.2bn, and total sales grew by 7.4% y-o-y to RMB18.8bn in 2016. During the period, sales generated by top 5 companies, accounted for more than 40% of the whole industry sales. Sales from top 20 companies out of over 100 peers took up more than 80% of market share.

In a nutshell, the sector is trending to be consolidated, favouring the existing market leaders to maintain or even expand their market shares.

According to Organisation Internationale des Constructeurs d'Automobiles (OICA), also called International Organization of Motor Vehicle Manufacturers, China has become the fastest growing countries in the development of auto industry. As of 2016, total car production in China reached 28mn units, representing a 15% y-o-y growth that outperformed the global 5% y-o-y growth.

Meanwhile, the number of vehicle in use (VIU) in China has been maintaining at an over 10% annual growth for the last decade, which delivered a CAGR of 18%. Apart from tyres being equipped with the newly built cars and vehicles, other car accessories such as tubes, dampers, and brake pads are also sources of consumption of rubber and rubber chemicals. The expanding volume of VIU that increasingly require recurring replacement tyres and components also drives it.

In 2005, China surpassed US and became the top tyre producer globally along with the domestic tyre production arriving at 250mn units. During the last decade, China has also been the largest tyre consumer and exporter in the world. Tyre production generated a CARG of 8%. It is expected that the volume will reach a new high of 635mn with 4.1% y-o-y growth in 2017.

Supply short and upswing prices of raw materials drove market prices to surge

Antioxidant, rubber accelerator, and insoluble sulphur, three main types of rubber chemicals, developed steadily during the post-global financial crisis period before 2014. It was the golden era for domestic rubber chemical sector in China. During the period, new entrants sprang up in China, catering to increasing demand resulting from the recovery of the tyre industry, while major foreign producers, namely Flexsys, Lanxess, and Agrofert, gradually reduce capacity owing to the withering cost and technique advantages.

Though China overtook other countries, becoming the market leader in the sector, overcapacity started to worsen domestically in 2014. The enactment of the new Environmental Protection Law in Jan-15 stroke the market, forcing a widespread shutdown of those mills who failed to meet environmental standards.

In 2016, supply-side reform initiatives in China further reshaped the market structure: environmentally obsolete capacities were gradually phased out, and supply ran short subsequently since those quality producers whose capacity were nearly fully utilised were not able to make up the demand gap.

In recent years, aniline market also encountered overcapacity. Since 2015, impacted by tightened environmental policies, destocking, and expanding export, aniline market had been restructuring amid slow growth. The average export price of aniline was on the course of recovery with 33% growth in recent two years. During the period, the average domestic price soared by 131% from RMB5,400/tonne to RMB12,500/tonne.

Shortage of supply led to a spike of rubber chemical prices from 2016 to 2017. The price growths of four types of rubber accelerators ranged from 15% to 30% during the period. Moving forward, new rubber chemicals capacity will commence operation in 2018; the supply shortage will be contained. As a result, the price growth will slow down this year.

Existing leading companies will reinforce the position amid market consolidation

With decades of development, rubber chemical industry in China has reached a mature stage after going through ramp-up of capacity, expansion of product mix, and improvement of techniques. At present, less than 50 domestic companies provide more than 80% of the total supply. In other words, these companies have dominated not just the domestic market but global market as well. Three main factors result in a more consolidated market in the foreseeable future:

Stringent environmental requirements are raising the entry barrier, restricting new capacity and phasing out small mills in China.

The cost of switching source of supply is high for tyre producers, especially global brands, resulting from due diligence on suppliers for a high standard of environmental protection and product specification.

The market leaders have cutting edges in production techniques, client base, and waste processing.

To ease the tight supply, we expect the industry to expand capacity by 6% from 2018 to 2019. However, the expansion will come from the existing market leaders. In a nutshell, the leaders will benefit more as the market consolidates.

INVESTMENT MERITS

Proven track record of stable profitability with new ramp-up of capacity

With a 40 year operating history, China Sunsine Chemical has grown into the second largest rubber chemical producer in terms of sales in China as of 2016. Currently, it has established clients base who have considered Sunsine as a key long-term supplier. Top 20 and 30 clients contribute over 40% and 70%of total turnover respectively.

As of 2016, Sunsine commands 18% and 31% of the world’s and China’s market share of rubber accelerator production. Over the years, the company has managed to deliver stable performance.

In 2012 and 2013, domestic market encountered headwinds like intense price competition due to overcapacity, resulting in an abnormal drop in profitability. On average, the company managed to deliver 25% gross profit margin (GPM) and 11% net profit margin (NPM).

Generally, Sunsine’s gross profit (GP)/tonne tracks the market spread (price of rubber accelerators - price of aniline). The deviation in 2015 and 2016 was owing to the production growth differentials. In 4Q17, the aniline price surged higher while the rubber chemical producers did not uplift selling price immediately. Usually, the market will take 1 or 2 months to adjust the markups accordingly. Nonetheless, the spread is 30%+ more in 2017 than in 2016.

Sunsine managed to deliver 5% y-o-y and 18.5% y-o-y output growth of rubber accelerator respectively while total production growth within the sector dropped by 9% y-o-y and 3% y-o-y during the period.

Moving forward, it is expected that Sunsine will maintain GPM of 27% and NPM of 12% amid the consolidation of supply in China.

Sunsine had set the mid-term capacity target by the 13th Five-Year Plan (end of 2020) as follows:

Rubber accelerators 117k tonnes.

Antioxidant 45k tonnes.

Insoluble sulphur 30k tonnes.

In 2018, the newly-added capacity (shown in Figure 16) are expected to be in operation. The targets for antioxidant and insoluble will be achieved and one-third of the 30k tonnes TBBS capacity expansion program will be accomplished in 2018. It is expected the remaining 20k tonnes to be from 2019 to 2020.

Sunsine has been heavily investing in environmental equipment

From 2012 to 2016, Sunsine’s capex on environmental protection totalled at RMB272mn. The recycle rate of waste water improved from 10% in 2012 to 87% in 2016. The conversion recovery rate of sulphur oxides was consistently above 99.5%, whereby the production cost dropped by RMB15mn respectively in 2015 and 2016. As of 2016, the capacity of solid waste treatment arrived at 30k tonnes.

Over the years, a reason Sunsine managed to maintain downstream corporate customers, especially top International tyre manufacturers, is their compliance to the increasingly high standard of environmental protection and waste discharge. These multinational corporations will conduct due diligence on the supplier before securing the supply contracts. Since Sunsine has established the sustainable relationships of cooperation with them, it is proved to meet their requirements consistently.

Sunsine has thrived during these rounds of market restructuring and transformation resulted from more stringent requirements of environmental protection domestically in recent years. Currently, the company is capable of taking advantage of market headwinds, as it constantly put efforts on environmental investments such as waste water treatment, solid waste treatment, and exhaust gas recycling facilities.

As of 3Q17, Sunsine had cash in hand amounting to RMB463mn. The remaining capex of Phase I of 10k-tonne capacity TBBS plant, 10k-tonne of insoluble sulphur plant, and a new heating plant, will be c.RMB100mn which is fully funded internally.

Since 2014, the company has increased the dividend to 1.5 SG cents, but the payout ratio dropped below 20% due to the substantial growth of bottom line.

Management has announced that the payout ratio will not be less than 20% in FY17 and FY18. As of 9M17, the net profit arrived at RMB209mn (FY16: RMB222mn). Therefore, the dividend for FY17 is expected to peak in history.

How Do We View China Sunsine?

In the short run, China Sunsine will see the 10% to 20% growth in both top line and bottom line, resulting from the ramp-up of capacity and stable profitability. However, we expect more frequent environmental inspection from the authorities in the next couple of years since pollution control is one of the main themes of the 13th Five Year Plan. Temporary stopwork may impact the daily operation. As long as the company continues to implement rigid waste discharge and emission control and environmental protection measures, it will keep the business on the run.

In the long run, It is expected that the leading market position will be further strengthened as the ongoing industry consolidation will contract the number of producers in the niche market. For Sunsine, this is an opportunity to expand the market share throughout organic growth from new self-built capacity or inorganic growth from acquisitions. In other words, horizontal integration will benefit the company.

KEY ASSUMPTIONS

We forecast the capacity-weighted average price based on the market average price and updated capacity of each product. We expect the average market price will rise by 2% per annum in 2018 and 2019.

We derive the sales volume based on the estimated utilisation rate of each product category and the given capacity.

VALUATION METHODOLOGY

Not only has Sunsine been delivering stable positive cash flows over the years and, but also does it not have borrowings.

We use discounted cash flow (DCF) which is based on free cash flow to equity (FCFE) as the valuation method to value Sunsine.

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